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January 15, 2013

El-Erian: Game Theory Predicts More Can-Kicking in Washington

Pimco CEO sees America mired in political dysfunction and economic malaise for years to come

Mohamed El-Erian, CEO of PIMCO. (Photo: AP)

Mohamad El-Erian predicts that Washington’s current round of fiscal talks focused on lifting America’s debt ceiling will likely result in more political gridlock and continued economic sluggishness.

In a provocative op-ed published Tuesday in the Atlantic, the PIMCO CEO derives this conclusion from the field of game theory, which shows how two parties, acting rationally, can produce a result that is bad for both of them.

Previous economic models assumed that people make rational choices. But game theory’s inventor, John von Neumann, sought to more realistically portray decision-making by considering that people’s choices are not made in a vacuum but typically in reaction to other people’s decisions and often under conditions of uncertainty.

“This intuitive framework,” writes El-Erian, “provides immediate insights into why members of Congress find it so difficult to come up with a coherent fiscal approach.”

“Good cooperative outcomes,” he adds, “are unlikely to emerge when, as is the case on today's Capitol Hill, individual and collective incentives are misaligned, access to information is asymmetrical, relative power is fluid, each party doubts that the other will deliver on their commitments, and there is no way to enforce credibility.”

The PIMCO CEO points to “fundamentally different (and, in part, quite dogmatic) views about the role, scale and scope of government” as a key source of acrimony.

The resulting contentiousness that blocks and limits compromise typically brings about a last-minute agreement in which “the majority of meaningful decisions are postponed, and both Democrats and Republicans emerge from the experience more bitter—at each other, and also within their respective parties.”

El-Erian says that that dysfunctional process now has left America with three big decisions, and failure to get them all right could knock the economy back into recession.

He says America “must lift the debt ceiling, resolve the sequester and agree on a continuing resolution to keep the government running.”

Game theory, El-Erian says, offers three insights on how this will all play out in the coming weeks. First, he dismally predicts that “the best we can hope for is a last-minute deal that kicks the can down the road.”

Second, he argues the GOP does not find itself in a corner this time, and consequently will have more equal bargaining power with the Democrats than it enjoyed in December, making it harder for the president to impose his preferred solution.

“At best, we will get by March a last-minute compromise that kicks most of the issues down the road; at worse, this will materialize after disruptions that sap more energy out of the economy. Whatever the outcome, Congress will again contribute to the persistence of sluggish growth and high unemployment, legitimating concerns that these will be further embedded in the structure of our economy for too many years to come.”